What is the Significance of the Fiat Currency?

Last month in an article entitled What Is Fiat Currency? we told you that “Fiat currency is a term that is used to describe a currency which is created by “fiat” or “arbitrary order or decree” of the government.” This month we would like to talk a little about the significance of Fiat currency. ~ Tim McMahon, editor.

Fiat Currency

Currency that is declared by a government to be a legal tender is referred to as a ‘Fiat Currency’. This type of currency owes its value strictly to the government’s acceptance of it for paying taxes and requiring its acceptance for “all debts public and private”. It is not backed by reserves or any physical commodity and is defined as nonconvertible paper money made legal tender by a government decree. It has no intrinsic value and is based on faith, as compared to the olden days, when most currencies were based on physical commodities like gold or silver.

Today, all of the currencies in the world are fiat money. Examples include: the U.S. dollar, the Japanese Yen, the British Pound, the Euro, etc. Not being linked to physical reserves, there is great risk of Fiat Currency losing value either gradually through inflation or rapidly through hyperinflation.

A Short History of the Fiat System

In the early eleventh century, Chinese Song Dynasty issued paper money subject to be redeemed for gold after three years. They were never redeemed, resulting in inflation due to a loss of confidence in the issuing authorities.

Result: The System was abandoned.

The twentieth century began with several countries experimenting with fiat currency. Most countries controlled the money-printing through their governments, but began massive printing due to high military expenses incurred during the First World War.

Result: The teens and twenties are littered with countries that experienced hyperinflation including:

Austria 1914- 1923 Inflation in one year (1922) reached 1426% and overall the consumer price index rose by a factor of 11,836.

In the fiat system, there is no constraint on the amount of money that can be created. History has shown that whenever there is uncontrolled printing of money the currency of that nation eventually gets devalued, resulting in inflation and/or hyperinflation.

When the government is not constrained by a gold or silver backing requirement, rather than default in its payments, it tends to take the easy way out and simply prints more money. Eventually, due to the increased printing, confidence in the money is lost and as fiat currency is based strictly on faith, it is rendered worthless. This ultimately results in the final phase of any fiat currency; that is Hyper-inflation. The U.S. is not immune to this process it has already suffered two hyperinflationary periods in its 200 year history. The first was in 1779 where it ened up with 47% inflation per month. And the second was during the Civil War from 1861-1865 where total hyperinflation of 1,200 to 1. See Confederate Inflation Rates